The term structure of inflation forecasts disagreement and monetary policy transmission

Summary

Focus

As inflation expectations play a crucial role in determining the actual price level, they are closely monitored by central banks. Our paper explores the implication of disagreement about inflation expectations on the transmission of monetary policy to both the real economy and financial markets. We focus on disagreement instead of consensus because, even when consensus inflation forecasts align perfectly with central bank inflation targets, individuals can still form varying beliefs about future inflation rates, raising concerns that inflation expectations might de-anchor.

Contribution

Our contribution is, first, that we exploit information in the term structure of disagreement over inflation forecasts. By contrast, most existing literature focuses on disagreement about inflation forecasts over a particular forecasting horizon. We propose a parsimonious term structure model for inflation forecasts disagreement, allowing us to decompose inflation forecasts disagreement into disagreement about the trend inflation and disagreement about the cyclical inflation. Second, our paper highlights the importance of disentangling the two components of disagreement because they have different effects on monetary policy efficacy. Lastly, our paper links inflation disagreement to the monetary policy framework.

Findings

We find that the term structure of inflation forecasts disagreement can be summarised by two factors: disagreement around the trend inflation and disagreement around the cyclical inflation. The cyclical inflation disagreement tends to weaken monetary policy efficacy. For one, when the cyclical inflation disagreement is high, monetary policy tightening tends to raise price levels instead of lowering them. For another, the cyclical inflation disagreement weakens the response of asset prices to monetary policy shocks. We show that active communication from the Federal Reserve is a useful tool in reducing inflation disagreement, especially disagreement about the cyclical inflation.

Abstract

The term structure of inflation forecasts disagreement in the US can be summarized by two components: disagreement about the trend inflation, and disagreement about the cyclical inflation. While the former has identical impacts on forecasts disagreement across forecasting horizons, the latter has more muted impacts on forecasts disagreement at longer forecasting horizons. Only the cyclical inflation disagreement has a significant impact on monetary policy efficacy. High  disagreement about the cyclical inflation undermines the transmission of monetary policy to both real economy and financial markets. Active communication from the Federal Reserve with the general public is a useful tool to reduce inflation disagreement, especially disagreement about the cyclical inflation.

JEL classification:  E31, E37, E52

Keywords: inflation expectation; forecasts disagreement; monetary policy transmission